Research Department Staff Forecast, April 2017

This document presents the forecast of macroeconomic developments
compiled by the Bank of Israel Research Department in April 2017. The forecast
was presented to the Monetary Committee on April 5, 2017, during its meeting
prior to the decision on the Bank of Israel interest rate on April 2017.
According to the staff forecast, gross domestic product (GDP) is projected to increase
by 2.8 percent in 2017 (although the basic growth rate[1] is expected
to be higher) and by 3.3 percent in 2018. The rate of inflation over the next year
(ending in the first quarter of 2018) is expected to be 0.7 percent. The Bank
of Israel interest rate is expected to remain at its current level of 0.1 percent
during the coming year, and to increase gradually from the second quarter of
2018.

Forecast

The Bank of Israel Research Department compiles a staff forecast of
macroeconomic developments on a quarterly basis. The staff forecast is based on
several models, various data sources, and assessments based on economists’
judgment. The Bank’s DSGE (Dynamic Stochastic General Equilibrium) model
developed in the Research Department—a structural model based on microeconomic
foundations—plays a primary role in formulating the macroeconomic forecast.[2] The model
provides a framework for analyzing the forces which have an effect on the
economy, and allows the integration of information from various sources into a
macroeconomic forecast for real and nominal variables, with an internally
consistent "economic story".

a. The global environment

Our assessments of expected developments in the global economy are based
mainly on projections by international institutions (the International Monetary
Fund and the OECD) and by foreign investment houses. These institutions revised
their forecasts for growth in advanced economies and for world trade slightly upward.
Our forecasts are for growth in advanced economies of 1.9 percent in 2017 and 2.0
percent in 2018. As for the world trade, we assume growth of 3.6 percent in
imports to the advanced economies in 2017 and growth of 3.8 percent in 2018 (in
line with the IMF forecast from January).

Based on assessments derived from the capital market (assessments based
on interest rate futures contract prices), the US federal funds rate is
expected to increase to around 1.3 percent at the end of 2017 and to around 1.7
percent at the end of 2018. (The median assessment of the members of the
Federal Open Market Committee is that the interest rate will increase more
rapidly—to 1.4 percent at the end of 2017 and 2.1 percent at the end of 2018.)
In contrast, the interest rate on deposits with the central bank in Europe is
expected to increase very moderately from its current level of -0.4 percent, and
to remain negative at -0.2 percent at the end of 2017 and -0.1 percent at the
end of 2018.

Global inflation is expected to continue increasing gradually. In accordance with the forecasts of the
international financial institutions, our assessment is that inflation in the
advanced economies will reach 1.8 percent in 2017 and 2 percent in 2018. Oil
prices declined recently to about $51 per barrel[3], and we
assume that they will remain at this level (compared with $54 that we assumed
in the previous quarter).

b. Real activity in Israel

GDP is expected to grow by 2.8 percent in 2017 and by 3.3 percent in
2018 (Table 1). The revision relative to the previous forecast derives mainly
from the extent to which vehicle purchases influenced GDP.[4] According
to the last estimate published by the Central Bureau of Statistics, vehicle
purchases increased in 2016 at a rate higher than our assessment in the
previous forecast. This is apparently
mainly due to purchases being brought forward because of the changes in vehicle
taxation that took effect in January 2017.
As such, it is expected that vehicle purchases will have a moderating
effect on GDP growth in 2017. Further
changes in vehicle taxation are expected in January 2019, and our assessment is
that they will also lead to purchases being brought forward, which will
increase the growth rate in 2018. It is worth emphasizing that the decline
expected in growth in 2017 relative to 2016 is to a large extent a result of
the fluctuations in vehicle purchases, and to a lesser extent a result of moderation
in the basic growth rate.[5]

The expected development of uses reflects a gradual transition to growth
that is based less on domestic uses and more on exports. The growth rate of private consumption is
expected to moderate after a long period in which it was more rapid than the
growth of other uses and of GDP. In contrast, the growth rate of exports is
expected to increase gradually with the expected recovery of world trade.

a) Annual average. Starting with this publication,
the reported figure is unemployment in the primary working ages
(24–65). In previous publications,
the reported figure related to the entire working-age population (age 15+).

b) Average CPI reading in the final quarter of the
year compared with the final-quarter average in the previous year.

c) End of the year.

Source: Bank of Israel.

c. Inflation and interest rate
estimates

In our assessment, the inflation rate in the four quarters ending in
the first quarter of 2018 will be 0.7 percent and in 2018 it will be 1.5 percent.The prices of imported products are expected to increase at a higher rate
than that of the past two years, as inflation expectations worldwide continue
to increase. In contrast, domestic prices are expected to continue increasing
moderately in the next two years, a result of the fact that moderating
forces—including increased competition—are expected to remain. The fact that
the labor market is near full employment is expected to continue supporting increased
wages, which may lead to an increase in domestic inflation. Expected inflation
in the next year is 0.5 percentage points lower than in the previous forecast,
mainly due to the appreciation of the shekel in terms of the effective exchange
rate since the previous forecast.

Table 2

Forecasts for inflation rate and interest rate for the coming
year

(percent)

Bank of Israel Research Department

Capital marketsa

Private forecastersb

Inflation ratec

0.7

-0.1

0.4

(range of forecasts)

(-0.4–1.0)

Interest rated

0.1

0.2

0.15

(range of forecasts)

(0.1–0.25)

a) Daily average for the month of March (up
to the 21st). Seasonally adjusted inflation expectations.

b) Inflation and interest rate forecasts are
those published after the publication of the CPI reading for February.

c) Inflation rate over the next year (Research
Department: in the four quarters ending in the first quarter of 2018).

d) The interest rate in one year (Research
Department: the interest rate in the first quarter of 2018). Capital markets
forecast derived from Telbor rates.

Source: Bank of Israel.

According to the Research Department’s assessment, the Bank of Israel
interest rate is expected to be 0.1 percent until the first quarter of 2018, and
to start increasing in the second quarter of 2018. The interest rate is
expected to remain at its current level in the coming year, in order to support
the return of inflation to within the target range and growth in economic activity.
The interest rate is expected to increase in the second quarter of the 2018, to
0.25 percent, against the background of an expected gradual increase in the
inflation rate and continued growth of GDP at a rate of around 3 percent. We
expect an additional increase in the fourth quarter 2018, to 0.5 percent. The
expectation of an increase in the interest rate is delayed by two quarters
relative the previous forecast due to the decline in the inflation forecast.

Table 2 indicates that the forecast compiled by the Research Department
regarding the interest rate in the coming year is similar to projections of
private forecasters and expectations derived from the capital markets. However,
with regard to inflation, the Research Department’s forecast is higher than
that of the professional forecasters and expectations derived from the capital
market.

d. Balance of risks in the
forecast

Several factors may lead to the domestic economy developing differently
than in the baseline forecast. These include uncertainty concerning tax
reductions (whether there will be any and to what extent), and uncertainty
concerning both the future development of the exchange rate and the extent to
which the appreciation of the shekel thus far will roll over to prices.

Regarding the global environment, there is uncertainty regarding the
pace of recovery of growth and of world trade, among other things against the
background of strengthening voices calling for pulling out of trade agreements
and for implementing isolationist economic policies, which was reflected in
recent political developments in the UK and the US.

Figures 1 to 3 present fan charts around the inflation rate, interest
rate and GDP growth forecasts. (The broken line represents the baseline forecast
from December.) The width of the fan is derived from the estimated
distributions of the shocks in the Research Department’s DSGE model.

Actual GDP Growth Rate in the Past
Four Quarters and Fan Chart of Expected Growth Rate

(Total GDP over the past four quarters
relative to GDP in the preceding four quarters)

The center of
the fan chart (the white line) is based on the Bank of Israel Research
Department assessment. The width of the fan is based on the Department’s
medium-scale DSGE (dynamic stochastic general equilibrium) model. The full fan
covers 66 percent of the expected distribution. The dotted line corresponds to
the previous staff forecast (published in December 2016). In terms of GDP
growth (Figure 3), until December 2016, the dotted line reflects the data and
estimates that were known at the time when the previous forecast was
formulated, while the solid line reflects the updated data and estimates (the
difference between them derives from new and data and revisions by the Central
Bureau of Statistics to the data).

SOURCE: Bank
of Israel Research Department.

[1]
The growth rate net of the fluctuations in vehicle imports.

[2] A Discussion Paper on the
model is available on the Bank of Israel website, under the title: “MOISE: A
DSGE Model for the Israeli Economy,” Discussion Paper No. 2012.06.

[3] According to the average of the last two weeks of March.

[4] According to the National Accounts recording rules,
taxation on imported vehicles is included in GDP. These imports also contribute to GDP through
their effect on importers’ added value.

[5] Our estimate for the effect of vehicle imports on GDP
growth is about 0.5%. That is, we estimate that the growth rate net of this
effect was 3.5%. In 2017 we estimate that the growth rate net of the effect of
vehicle imports will be 3.2%, and in 2018, 3.0%.